The Aussie dollar plunged to two-and-a-half
year lows last week, with some forecasters predicting even lower levels in the
weeks and months to come. While the market has showed some buoyancy to recover
from a low of 70.41 US cents, a strong greenback and rising international
tensions have some experts predicting the dollar to fall well into the 60s by
next year. While currency movements are almost impossible to predict, the
future of the Aussie dollar will depend greatly on the yield spread with the
greenback and the domestic terms of trade.

The Aussie dollar has performed well in
recent times, being above parity just five years ago and more that 80 US cents
at the start of 2018. The recent high of 81.35 US cents in January seems like a
long time ago, however, with the currency falling sharply since then with very
little resistance. While predicting currency movements is notoriously
difficult, it's important to understand what's driving down the Aussie if we
want to guess where it will go next.

With currency movements always coming in
pairs, it's not so much a case of what's driving the Aussie dollar down but
what's making the US dollar rise. In many ways, the severity of the current
movement is simply due to the interest rate differential between the US and
Australia. According to MacroBusiness Fund chief strategist David
Llewellyn-Smith, “The principal reason it’s falling is because the yield
spread, basically the difference between interest rates in the US and Australia,
has turned very negative... The US now has much higher interest rates than we
do.”

While the numbers may seem similar, with
interest rates at 2.25 percent in the US and 1.5 percent down-under, momentum
is very much not in our favour. Last month the US Federal Reserve raised its
benchmark interest rate for the third time this year, with plans for another
hike in December, three more in 2019, and at least one more in 2020. While the
economic situation could change a lot between now and then, the Reserve Bank of
Australia has not increased its official cash rate since November 2010. While
the RBA would like to increase rates, some commentators think a cut is more
likely, which will put even more pressure on the Aussie dollar.

Along with interest rates, the other key
driver of the Aussie dollar is the terms of trade. Commonly defined as the
ratio of import to export prices, the terms of trade highlights the amount of
money coming in and out of the country. High commodity prices typically mean a
high Aussie dollar, with a strong historic relationship existing between commodities
and the local currency. What's interesting at the moment is the lack of
correspondence between our two biggest exports, coal and iron which are
fetching relatively high prices, and the Aussie dollar.

According to Mr Llewellyn-Smith,
"Right now if that relationship held, the Aussie would be up around 85
cents based on the terms of trade... So you’ve got this tug of war between the
terms of trade and the yield spread.”One other significant factor that is contributing to the low Aussie
dollar is the growing trade war between the US and China. With so many of our
exports going to China, this could cause serious economic and political
disruptions as we're either forced to make a choice or go through the
experience of being squashed between two global superpowers.